Wednesday, April 05, 2017

Lots To Chew On In The FOMC Minutes

The minutes of the March FOMC meeting confirmed that the Fed remains poised to tighten policy further, first via raising the federal funds rate followed by action to reduce the balance sheet later in the year. It appears most likely that the Fed will see the latter as a substitute for the former. That means rate hikes would perhaps be on hold during the start of 2018 as the Fed assesses the efficacy of its actions. To be sure, however, the pace and mix of tightening remain data dependent. With the Fed in general agreement that the economy is near full employment, an uptick in either the pace of growth or inflation concerns will prompt the Fed begin murmuring about an accelerated the pace of tightening.

The Fed tackled balance sheet strategy early in the meeting. On timing, the policymakers thought thought it soon be upon us:

Provided that the economy continued to perform about as expected, most participants anticipated that gradual increases in the federal funds rate would continue and judged that a change to the Committee's reinvestment policy would likely be appropriate later this year.

Now place that prediction in the context of this discussion from the committee action portion of the minutes:

Members generally noted that the increase in the target range did not reflect changes in their assessments of the economic outlook or the appropriate path of the federal funds rate, adding that the increase was consistent with the gradual pace of removal of accommodation that was anticipated in December, when the Committee last raised the target range.

The median rate projection in March held at a total of three hikes for 2017. The Fed believes that the March rate hike was consistent with the gradual pace of policy removal as anticipated in December. Assume then that the economy continues to stay the course, holding generally in line with the Fed's forecasts. Suppose that means the current pace of tightening holds as well.

A continuation of the current pace of tightening - one action per quarter - would put rate hikes in June and September. At that point, the target range in 1.25-1.5%. That is roughly halfway to the currently anticipated neutral rate. Then the normalization of rate policy would be well underway, and then, in December, the Fed switches gears to balance sheet reduction. Later this year, as stated in the minutes.

That suggests that "gradual" means policy action once a quarter. (Remember the Fed began 2016 thinking four hikes? I think once a quarter seems about right to them.) If so, and they still intend a total of three rates hikes and balance sheet action for 2018, it implies they think, reasonably, that action on balance sheet reduction is a substitute for rate hikes. And, furthermore, that the balance sheet forecast is implicitly built into the median rate forecast. If not for having to deal with the balance sheet, I suspect the median forecast for 2017 would be 4 rate hikes.

That gets you through 2017. What about 2018? They probably have in mind that the phasing out of reinvestments could take six months, though this has not yet been decided. Back to the minutes:

An approach that phased out reinvestments was seen as reducing the risks of triggering financial market volatility or of potentially sending misleading signals about the Committee's policy intentions while only modestly slowing reductions in the Committee's securities holdings. An approach that ended reinvestments all at once, however, was generally viewed as easier to communicate while allowing for somewhat swifter normalization of the size of the balance sheet.

The Fed could go cold turkey on reinvestments, option 2, but I suspect will choose to ease into balance sheet reduction, option 1. Less chance of disrupting financial markets. That would mean policy action at the second meeting of 2018 to get reinvestment strategy on its final path, followed up quarterly rate hikes after that.

Assuming this is the schedule they have in mind, policymakers expect to tighten policy once per quarter for the next two years, trading off between rate hikes and balance sheet policy. The risk, however is that balance sheet reduction takes longer than expected, or it more disruptive than expected, thus reducing the scope for rate hikes in 2018. Time will tell on that one.

The Fed, however, could step up the pace of action. On the mandates:

Nearly all participants judged that the U.S. economy was operating at or near maximum employment. In contrast, participants held different views regarding prospects for the attainment of the Committee's inflation goal.

Inflation continues to be the sticking point. If inflationary pressures were more visible, the Fed would be acting more aggressively. Watch this space, and core-PCE inflation in particular. It picked up in January and February. If that continues into March and April, the Fed will worry that they have pushed "gradual" as far as it will go. Watching employment, however, is a bit more tricky. For now, I expect the Fed to get nervous of a significant undershoot if the unemployment rate dips much further. Persistent low inflation, however, could yield a decrease in the Fed's estimate of the natural rate of unemployment.

Finally, note this:

In their discussion of recent developments in financial markets, participants noted that financial conditions remained accommodative despite the rise in longer-term interest rates in recent months and continued to support the expansion of economic activity. Many participants discussed the implications of the rise in equity prices over the past few months, with several of them citing it as contributing to an easing of financial conditions. A few participants attributed the recent equity price appreciation to expectations for corporate tax cuts or to increased risk tolerance among investors rather than to expectations of stronger economic growth. Some participants viewed equity prices as quite high relative to standard valuation measures. It was observed that prices of other risk assets, such as emerging market stocks, high-yield corporate bonds, and commercial real estate, had also risen significantly in recent months. In contrast, prices of farmland reportedly had edged lower, in part because low commodity prices continued to weigh on farm income. Still, farmland valuations were said to remain quite high as gauged by standard benchmarks such as rent-to-price ratios.

Fed officials aren't growing nervous about just equities. They are seeing high prices across a wide range of risky assets. If it was just one asset class, they might conclude that it doesn't pose systemic risk for the US economy. Or they might conclude that macro prudential policies were sufficient to maintain financial stability. But a wide range of assets might require a more blunt tool - like higher rates. Another space to watch. Where this space gets messy is the tendency of equity prices to remain high even as the Fed tightens - a pattern which may induce the Fed to tighten much more aggressively than they should.

Bottom Line: The Fed clearly anticipates more tightening, likely at a pace of one action per quarter between interest rates and balance sheet. My interpretation of the minutes is that with the economy near full employment and assuming asset prices stay high, it wouldn't take much movement on the labor market or inflation expectations to make Fed officials sufficiently nervous that you begin to hear more about stepping up the pace of tightening.

Comments

Lots To Chew On In The FOMC Minutes

The minutes of the March FOMC meeting confirmed that the Fed remains poised to tighten policy further, first via raising the federal funds rate followed by action to reduce the balance sheet later in the year. It appears most likely that the Fed will see the latter as a substitute for the former. That means rate hikes would perhaps be on hold during the start of 2018 as the Fed assesses the efficacy of its actions. To be sure, however, the pace and mix of tightening remain data dependent. With the Fed in general agreement that the economy is near full employment, an uptick in either the pace of growth or inflation concerns will prompt the Fed begin murmuring about an accelerated the pace of tightening.

The Fed tackled balance sheet strategy early in the meeting. On timing, the policymakers thought thought it soon be upon us:

Provided that the economy continued to perform about as expected, most participants anticipated that gradual increases in the federal funds rate would continue and judged that a change to the Committee's reinvestment policy would likely be appropriate later this year.

Now place that prediction in the context of this discussion from the committee action portion of the minutes:

Members generally noted that the increase in the target range did not reflect changes in their assessments of the economic outlook or the appropriate path of the federal funds rate, adding that the increase was consistent with the gradual pace of removal of accommodation that was anticipated in December, when the Committee last raised the target range.

The median rate projection in March held at a total of three hikes for 2017. The Fed believes that the March rate hike was consistent with the gradual pace of policy removal as anticipated in December. Assume then that the economy continues to stay the course, holding generally in line with the Fed's forecasts. Suppose that means the current pace of tightening holds as well.

A continuation of the current pace of tightening - one action per quarter - would put rate hikes in June and September. At that point, the target range in 1.25-1.5%. That is roughly halfway to the currently anticipated neutral rate. Then the normalization of rate policy would be well underway, and then, in December, the Fed switches gears to balance sheet reduction. Later this year, as stated in the minutes.

That suggests that "gradual" means policy action once a quarter. (Remember the Fed began 2016 thinking four hikes? I think once a quarter seems about right to them.) If so, and they still intend a total of three rates hikes and balance sheet action for 2018, it implies they think, reasonably, that action on balance sheet reduction is a substitute for rate hikes. And, furthermore, that the balance sheet forecast is implicitly built into the median rate forecast. If not for having to deal with the balance sheet, I suspect the median forecast for 2017 would be 4 rate hikes.

That gets you through 2017. What about 2018? They probably have in mind that the phasing out of reinvestments could take six months, though this has not yet been decided. Back to the minutes:

An approach that phased out reinvestments was seen as reducing the risks of triggering financial market volatility or of potentially sending misleading signals about the Committee's policy intentions while only modestly slowing reductions in the Committee's securities holdings. An approach that ended reinvestments all at once, however, was generally viewed as easier to communicate while allowing for somewhat swifter normalization of the size of the balance sheet.

The Fed could go cold turkey on reinvestments, option 2, but I suspect will choose to ease into balance sheet reduction, option 1. Less chance of disrupting financial markets. That would mean policy action at the second meeting of 2018 to get reinvestment strategy on its final path, followed up quarterly rate hikes after that.

Assuming this is the schedule they have in mind, policymakers expect to tighten policy once per quarter for the next two years, trading off between rate hikes and balance sheet policy. The risk, however is that balance sheet reduction takes longer than expected, or it more disruptive than expected, thus reducing the scope for rate hikes in 2018. Time will tell on that one.

The Fed, however, could step up the pace of action. On the mandates:

Nearly all participants judged that the U.S. economy was operating at or near maximum employment. In contrast, participants held different views regarding prospects for the attainment of the Committee's inflation goal.

Inflation continues to be the sticking point. If inflationary pressures were more visible, the Fed would be acting more aggressively. Watch this space, and core-PCE inflation in particular. It picked up in January and February. If that continues into March and April, the Fed will worry that they have pushed "gradual" as far as it will go. Watching employment, however, is a bit more tricky. For now, I expect the Fed to get nervous of a significant undershoot if the unemployment rate dips much further. Persistent low inflation, however, could yield a decrease in the Fed's estimate of the natural rate of unemployment.

Finally, note this:

In their discussion of recent developments in financial markets, participants noted that financial conditions remained accommodative despite the rise in longer-term interest rates in recent months and continued to support the expansion of economic activity. Many participants discussed the implications of the rise in equity prices over the past few months, with several of them citing it as contributing to an easing of financial conditions. A few participants attributed the recent equity price appreciation to expectations for corporate tax cuts or to increased risk tolerance among investors rather than to expectations of stronger economic growth. Some participants viewed equity prices as quite high relative to standard valuation measures. It was observed that prices of other risk assets, such as emerging market stocks, high-yield corporate bonds, and commercial real estate, had also risen significantly in recent months. In contrast, prices of farmland reportedly had edged lower, in part because low commodity prices continued to weigh on farm income. Still, farmland valuations were said to remain quite high as gauged by standard benchmarks such as rent-to-price ratios.

Fed officials aren't growing nervous about just equities. They are seeing high prices across a wide range of risky assets. If it was just one asset class, they might conclude that it doesn't pose systemic risk for the US economy. Or they might conclude that macro prudential policies were sufficient to maintain financial stability. But a wide range of assets might require a more blunt tool - like higher rates. Another space to watch. Where this space gets messy is the tendency of equity prices to remain high even as the Fed tightens - a pattern which may induce the Fed to tighten much more aggressively than they should.

Bottom Line: The Fed clearly anticipates more tightening, likely at a pace of one action per quarter between interest rates and balance sheet. My interpretation of the minutes is that with the economy near full employment and assuming asset prices stay high, it wouldn't take much movement on the labor market or inflation expectations to make Fed officials sufficiently nervous that you begin to hear more about stepping up the pace of tightening.